Many investors' portfolios include investments in options, as well as mutual funds, stocks, and bonds. Options allow investors to manage and/or hedge risks. There are two popular types of options: American options, and European options. American options can be exercised at any time between the date of purchase and the expiration date. European options are different from American options in that they can only be exercised at the end of their lives.
In order to balance a hedged portfolio, it is necessary to calculate the fair values of associated options. The price of a stock within a portfolio may change many times a second. Therefore, it is necessary to calculate the fair price of American options quickly.
One popular way to calculate the proper price of American options is following the technique of Longstaff and Schwartz, known as the Least Square Monte Carlo (LSMC). The LSMC technique calculates the future price as if the options were European, and then uses least squares curve fitting to work backwards to the next date. Currently, portfolios are balanced overnight. Current techniques, such as the LSMC, do not provide option prices sufficiently fast for real-time portfolio balancing.
What is needed is a new technique for calculating American options which is sufficiently fast to provide real-time portfolio balancing. The invention addresses this need.